Fund Managers and Passive Investing

The fund management industry has been getting a lot of bad press recently. Firstly because so many of them fail to beat simple strategies like investing in a FTSE100 index tracker. Of course, in aggregate the fund universe is the stock market, so its clearly impossible for them to beat the stock market in aggregate. Ironically, if all the funds controlled by active fund management where placed in passive funds, it would create exactly the situation needed for the fund management industry to create alpha and thrive.

However, its especially hard to understand, because almost every other passive strategy, e.g. buying an equal weighted portfolio instead of a cap weighted portfolio like the FTSE100, will massively outperform a cap weighted index. The Nasdaq-Apple phenomenon illustrates precisely the danger of Cap weighting. At one point Apple comprised nearly 40% of the index (it was later limited to 20% by official decree), which means that you are not getting the benefits of diversification that you would expect in a portfolio, since most of your value is in a handful of positions. The top ten positions of the S&P500 have 20% of the value, you need just 32 to companies to have half the index by value. The bottom fifty companies make up just 1% of the market cap. Is it really worth the trading costs to rebalance 50 positions worth just 0.02% each? Its trivial to see that if every company has identical profiles, the minimum variance portfolio will be equally weighted.

We have not even talked about Fee structures. Many funds have total expense ratios exceeding two percent. Truly awful. Investment trusts as a group seem to do better, averaging about 1%. Still, in all this, I came across a surprising graph in the small cap sector:

Virtually every small cap fund substantially outperformed the FTSE small cap benchmark.

Virtually every small cap fund substantially outperformed the FTSE small cap benchmark over three years. That blue dot over on the left is the benchmark. Risk is vertical and return is horizontal.

I have no idea how this can even be true. Perhaps the FT is selecting only the best performers. Perhaps many or most small cap funds are actually only partially invested in small caps? Here is the graph for Flex cap equity.

Again the Benchmark seems to be a bizarrely low performer.

Again the Benchmark seems to be a bizarrely low performer.

These graphs were quietly snipped of the FT website, but again, the FTSE all share has indeed managed just 2.5% annualised, so it seems plausible that their `flex cap’ index might have done this badly. But how can every fund outperformed so massively? A quick check on my morningstar driven research platform finds 28 small cap funds, but only 9 of them are more than three years old.

Does the fund industry routinely close and reopen funds in-order to erase the memory of bad performance? This is really the only possible explanation. No wonder funds look attractive to retail investors when fund managers continually erase fund that under-perform the index, and only those that look good survive.

If that is what is happening, the regulators ought to step in, as these graphs are deeply misleading, despite being superficially accurate.

However, there is a slight  upside in this for the retail investor. If funds are killed of for relative under performance (and your money returned), then sooner or later you will end up in a fund that is beating the index. Of course, if that out performance is essentially random, then you would be better off indexing and saving your fees, since it is impossible to generate useful work from a random process*. On the other hand, if manager out performance is persistent, and there is reasonable, though not conclusive, evidence that it is, then sooner or later you are likely to end up in a winner. This is interesting enough that I would like to model it. Does anyone have access to fund data including funds that were closed? Ten years would be enough.

*Yes, I did just apply the second law of thermodynamics to Finance. It really works too. Try this brain teaser: suppose you wish for a population to have more boys than girls, is there any strategy which can produce this result? Strategies like: I will keep having children till I get a boy. I will continue having children till I have more boys than girls, etc. Strategies involving killing people are not allowed.


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About worldofinterest

I know I live in my own world, but I like it: they know me here.

One response to “Fund Managers and Passive Investing”

  1. brownderrick807 says :

    Great post. I didn’t think of the possibility of the industry just opening and closing funds to just hide their tracks, but now that you have mentioned it, it does seem strangely plausible.

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